Bullish on Financials: Investors Banking on Earnings and Dividend Growth

Includes: BAC, BEN, C, JPM, KBE, USB, WFC
by: Alan Brochstein, CFA

In early October, I suggested that Financials might soon join the party, as they were still mired then in a trading range. After acknowledging the well-known risks, I pointed out several positives:

  • Improving Charts
  • Good Valuations
  • Risk-taking in favor again
  • Improving Breadth

While it has been Energy getting all of the attention lately, Financials have been staging a stealth run at leadership among the remaining sectors. With the clarity on dividend payments fueling a flood of announcements this week, I thought it might make sense to take another look at the sector.

So far in 2011, only 4 sectors are up. Energy, of course, is dominating, with cyclical Industrials and Consumer Discretionary showing green as well. Financials, at +1.95%, are in a solid 3rd place. After the past few years, this is quite a change for the sector, which led on the way down and lagged on the way up. Looking relative to the S&P 500 since I called for some focus on Financials, you can see that after lagging into December, the stealth leadership is now quite apparent:

(Click to enlarge)

So, we have now a good chart in my view as well as marginally favorable relative strength. Valuation for the entire sector remains quite attractive, with a 2011 PE of just 12X according to Standard & Poors.

While I like the idea of embracing Financials a bit more, it's probably time to be thinking about skewing towards banks. In my Top 20 Model Portfolio, my only holding currently is money manager Franklin Resources (NYSE:BEN), so I am definitely just thinking out loud for now. In Conservative Growth/Balanced, we own BEN as well as a very small bank.

For those of you like me who don't have a great confidence in their ability to pick among the individual banks, it's worth considering SPDR KBW ETF (NYSEARCA:KBE), which is designed to track the KBW Bank Index (BKX). It has tracked the overall sector over the past year and for longer periods, though the KBE fell short of its April peak in contrast to XLF making a new high.

You can visit the website to learn more, but I will share a few basics. First, there are 24 holdings in all, with the top 5 making up 36% and the Top 10 accounting for 59%. Second, the size of the ETF is $1.75 billion. Third, the average daily volume is 5.4mm, about 8% of the shares outstanding. Finally, gross expenses represent 0.35%.

I loaded all of the holdings into my analytical system and found a couple of factors that suggest investors could become much more interested over the balance of the year. The overall dividend is just 1.7%, which is only in line with the S&P 500, but this doesn't take into account the several hikes announced yesterday. Over 1/2 the names pay only a very nominal dividend, with 14 of the 24 paying less than 1%. Above-average and rising dividends is likely to drive focus on the sector.

An additional feature of these companies is massive earnings growth in 2012. While the overall market is likely to experience modest earnings growth, the large banks are likely to enjoy explosive growth. While the strong growth in 2011 is already in the numbers (13.5X 12-months forward on a weighted basis), what many might not realize is that the earnings recovery is projected to continue the following year. To me, this seems realistic as the legacy issues fade and lending continues to recover. On a weighted basis, 2012 earnings are projected to grow 34% in 2012.

Honing in just on the Top 5, which include JP Morgan (NYSE:JPM), Bank of America (NYSE:BAC), Citigroup (NYSE:C), Wells, Fargo (NYSE:WFC) and U.S. Bancorp (NYSE:USB), the picture is even clearer. The 5 names have forward PE ratios of 9.5-12.5, so below the overall average. Their earnings growth in 2012 is projected to be 20-25% typically, with JPM at 17% and BAC at 40%. C pays no dividend, while the others are all below 1% (prior to the hikes yesterday).

So, I want to reiterate my bullishness on the Financials that I conveyed in October and to suggest that the recent relative performance might be suggestive of a sustainable trend of beating the market over the balance of the year. Sentiment remains subdued, valuation low and the charts good. I think that the trends in dividends and earnings for big banks are likely to capture a lot of attention in coming months.

Disclosure: I am long BAC.